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Dynamic Oligopoly and Price Stickiness DYNAMIC OLIGOPOLY AND PRICE STICKINESS Olivier Wang Iván Werning WORKING PAPER 27536 NBER WORKING PAPER SERIES DYNAMIC OLIGOPOLY AND PRICE STICKINESS Olivier Wang Iván Werning Working Paper 27536 http://www.nber.org/papers/w27536 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 July 2020 In memory of Julio Rotemberg, who was ahead of his time, many times. We thank comments by Fernando Alvarez, Anmol Bhandari, Ariel Burstein, Glenn Ellison, Fabio Ghironi, Francesco Lippi, Simon Mongey, as well as seminar and conference participants at MIT, UTDT lecture in honor of Julio Rotemberg, EIEF Rome, SED 2018 meetings, Minneapolis Federal Reserve Bank and NBER-SI 2020. All remaining errors are ours. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications. © 2020 by Olivier Wang and Iván Werning. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. Dynamic Oligopoly and Price Stickiness Olivier Wang and Iván Werning NBER Working Paper No. 27536 July 2020 JEL No. E0,E3,E5 ABSTRACT How does market concentration affect the potency of monetary policy? The ubiquitous monopolistic-competition framework is silent on this issue. To tackle this question we build a model with heterogeneous oligopolistic sectors. In each sector, a finite number of firms play a Bertrand dynamic game with staggered price rigidity. Following an extensive Industrial Organization literature, we focus on Markov equilibria within each sector. Aggregating up, we study monetary shocks and provide a closed-form formula for the response of aggregate output, highlighting three measurable sufficient statistics: demand elasticities, market concentration, and markups. We calibrate our model to the empirical evidence on pass-through, and find that higher market concentration significantly amplifies the real effects of monetary policy. To separate the strategic effects of oligopoly from the effects this has on residual demand, we compare our model to one with monopolistic firms after modifying consumer preferences to ensure firms face comparable residual demands. Finally, the Phillips curve for our model displays inflation persistence and endogenous cost-push shocks. Olivier Wang New York University New York, NY 10012 [email protected] Iván Werning Department of Economics, E52-536 MIT 50 Memorial Drive Cambridge, MA 02142 and NBER [email protected] 1 Introduction The recent rise in product-market concentration in the U.S. has been viewed as a driving force behind several macroeconomic trends. For instance, Gutiérrez and Philippon (2017) document an increase in the mean Herfindahl-Hirschman index since the mid-nineties, and argue that it has weakened investment. Autor, Dorn, Katz, Patterson and Van Reenen (2017) and Barkai (2020) relate the rising concentration of sales over the past 30 years in most US sectors to the fall in the labor share.1 What are the implications of trends in concentration or market power for the trans- mission of monetary policy? Do strategic interactions in pricing between increasingly large firms amplify or dampen the real effects of monetary shocks? The baseline New Keynesian model is not designed to address these questions. Following the recognition that some form of imperfect competition and pricing power is required to model nomi- nal rigidities, the New Keynesian literature has been built on the tractable paradigm of monopolistic competition, pervasive in other areas of macroeconomics and international trade. Under monopolistic competition, markups only depend on tastes, through con- sumers’ elasticity of substitution between competing goods, which leaves no room for changes in concentration to affect markups or monetary policy. In this paper, we provide a new framework to study the link between market structure and monetary policy. We generalize the standard New Keynesian model by allowing for dynamic oligopolistic competition between any finite number of firms in each sector of the economy, also allowing for heterogeneity across sectors. In each sector, firms compete by setting their prices, but they do so in a staggered and infrequent manner due to nom- inal rigidities. We use this model to study the aggregate real effects of monetary shocks and highlight the restrictions imposed by monopolistic competition. Departing from mo- nopolistic competition to study oligopoly poses new challenges, because it requires solv- ing a dynamic game with strategic interactions at the sectoral level and embedding it into a general equilibrium macroeconomic model. We focus on Markov equilibria of our dy- namic game, where the pricing strategy, or reaction function, of every firm is a function of the prices of its competitors. Despite these complexities, our first result derives a closed-form formula for the re- sponse of aggregate output to small monetary shocks. Our formula inputs the cross- sectoral distribution of three sufficient statistics: market concentration as captured by the effective number of firms within a sector, demand elasticities, and markups. The intu- 1Rossi-Hansberg, Sarte and Trachter(2020) document, however, that diverging trends in national and local measures of concentration. We will discuss how to interpret our results in light of these two views. 2 ition is based on the link between the steady state markup that can be sustained in an oligopolistic equilibrium and the slope of the reaction function of each firm to the prices of its competitors. All else equal, steeper reaction functions lead to higher equilibrium markups: each firm has little incentives to cut prices when it knows that this would lead its rivals to cut prices as well for some time. Inverting the logic, we can infer from high observed markups that reaction functions are steep and therefore complementarities in pricing are strong, which in turn implies a slow pass-through of monetary shocks into prices and therefore large real effects on output. In this way, our formula encapsulates a tight restriction between endogenous markups and stickiness, conditional on demand elasticities.2 While our key sufficient statistics, demand elasticities and markups, can be estimated at any given point in time, they are endogenous objects that change in reaction to shifts in fundamentals. To perform counterfactual experiments, we take a more structural ap- proach and solve numerically the oligopolistic equilibrium in terms of fundamentals. We use a flexible Kimball(1995) demand system that allows us to parametrize separately demand elasticities and superelasticities, as the latter can affect monetary policy trans- mission through variable markups even under monopolistic competition. In our main exercise, we vary the number of firms n in each sector while keeping pref- erence parameters fixed. We find that higher concentration (lower n) can significantly amplify or dampen the real effects of monetary policy, depending on how properties of the residual demand vary with n. When preferences are CES, higher concentration am- plifies monetary policy transmission, but the maximal effects, attained under duopoly, remain limited: the half-life of the price level in reaction to monetary shocks is around 40% higher than under monopolistic competition. With Kimball preferences and suffi- ciently high superelasticity, higher concentration dampens monetary policy transmission. Moreover, the dampening can be arbitrarily large. We use evidence on the heterogeneity in idiosyncratic cost pass-through across small and large firms from Amiti, Itskhoki and Konings (2019) to calibrate how concentration affects the shape of demand functions, and find substantial amplification. The rise in the average Herfindahl index observed in the U.S. since 1990 increases the response of output (and decreases the response of inflation) to monetary shocks by around 15%. What explains these results? The number of competitors in a market has an effect on firms’ strategic incentives, but also on the shape of the residual demand faced by each 2In the standard monopolistic competition model desired markups are constant and only a function of the demand elasticity. However, in a strategic environment the endogenous markup is no longer a simple function of the demand elasticity. 3 firm. We disentangle the two ways through which oligopolistic competition differs from monopolistic competition. On the one hand, “feedback effects” make each firm care about its rivals’ current and future prices when setting its price. On the other hand, “strategic ef- fects” arise because each firm realizes its current pricing decision can affect how its rivals will set their prices in the future. We isolate these two effects for each n, by comparing the oligopolistic model with n firms to a “non-strategic” benchmark economy featuring monopolistic competition and Kimball preferences modified to match the elasticity and superelasticity of the residual demand in the finite n model. We find that departures from monopolistic competition are mostly working through feedback effects, that is changes in the shape of residual demand. While strategic effects matter for the level of steady state markups, they only have a modest impact on monetary
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